Investments in private companies by way of share purchases from existing shareholders (secondary transactions) raise a unique set of complexities, which are often overlooked. Share issuances in company-led financing rounds (primary issuances) grab most of the headlines. However, secondary transactions present important opportunities for purchasers and paths to exit for existing shareholders, and they often mark a milestone for the company itself. At the same time, a purchaser can feel that it must walk a tightrope to diligence and structure and complete a secondary transaction – although, upon closer review, there is often significant room for negotiation and creativity. In this article, we identify 10 points to note in secondary transactions, with practical tips for investors to address them.
Lifecycle of Investment. The 10 key issues for secondary acquisitions that we discuss below relate to, and impact, each stage of the lifecycle of the purchaser’s investment. That starts with the initial phase of evaluating, negotiating, structuring, and executing the investment construct. This initial phase of the investment lifecycle also sets the basis for, and must anticipate, the subsequent stages in the lifecycle of the purchaser’s investment – principally, the matrix of rights that the purchaser will have in relation to the Company following its investment and the purchaser’s exit horizon and related exit rights.
Thinking Ahead in Primary Investments. Investors that understand the key issues for secondary acquisitions will be more adept at negotiating and structuring their primary investments into the Company. Certain issues we raise here may be mitigated, if not entirely pre-empted, in the transaction documents for the primary investment. An initial investor will have a clearer path toward exiting its investment by way of a secondary sale if the Company’s governing documents do not contain provisions that are (perhaps inadvertently) “toxic” or “repellent” to most secondary investors.
Ground Rules for Secondary Deals – and Variations. We cover the six principal “ground rules” for most secondary transactions, along with potential variations and strategies to facilitate the deal. The principal considerations for a purchaser in evaluating and navigating the “ground rules” for a given transaction will be:
- Investment Construct and Transaction Structuring – Rights and Obligations Matrix: While secondary acquisitions might appear, at first glance, to be “take it or leave it” propositions, this is rarely the case. Sophisticated investors approach the investment terms and structuring in a secondary deal as they do in a primary investment. Evaluating the terms of securities for sale, as well as the matrix of rights and obligations that an investor would assume upon becoming a shareholder, is of particular importance, both in light of any shareholders agreement and under the relevant corporate law.
- Company Cooperation in the Sale Process: One of the threshold questions is whether the parties will seek to work with the Company, or around the Company, in completing the share sale. The Company’s cooperation can greatly facilitate a deal, even where it is not strictly required, and we describe considerations in “winning over” the Company.
- Conducting Appropriate Diligence: The purchaser will often find it more challenging to conduct fulsome diligence in a secondary transaction, as compared to a primary investment. However, there can be avenues for adequate diligence, even where the Company is not cooperating.
- Consent Requirements for the Transaction: Consent requirements for the transaction are not always black and white in the Company’s shareholders agreement, and investors may have to assess ways to structure around them.
- Navigating Transfer Restrictions – ROFR, ROFO, and Tag-Along Rights: Most secondary transfers are subject to one or more of a right of first refusal (ROFR), right of first offer (ROFO), or tag‑along right in favor of the Company’s other investors, and these rights can complicate, or even block, any secondary sale.
- Negotiating Variations to the Shareholders Agreement: A purchaser typically has little choice but to accept most terms of the Company’s shareholders or investor rights agreement that others have already agreed with the Company, but, on a handful of important points (such as non-invest restrictions), there is often room for amendments or waivers – and these might make the difference between an attractive and unattractive investment opportunity.
Key Purchase Agreement Terms. In addition to the above six principal “ground rules,” we also focus on key terms that a purchaser should address in its share purchase agreement with the selling shareholder. Key considerations in this regard include the following:
- Assignment of Seller’s Rights: Contractual rights do not automatically “attach” to shares being transferred and must be specifically addressed in the transaction documents. These can include “fundamental” rights for a purchaser, such as board representation rights, veto rights, and certain exit and liquidity rights. Further complications can arise if the seller is retaining a portion of its shareholdings, and an allocation of rights must be addressed.
- Purchase Price Mechanics and Variations: Most secondary transactions follow a simple purchase price construct, with an agreed upon per share price that is not subject to adjustment or holdback. However, other pricing structures are available – and may be useful to bridge valuation gaps. These can include earnouts, holdbacks, and other deferred payment structures, as well as seller rights in “quick flips” of the acquired shares.
- Representations, Warranties, and Indemnities: In marked contrast to primary investments, an investor typically receives very limited representations, warranties, and indemnities in secondary transactions. However, there is some room for negotiation on the margins, particularly if the seller is closely involved in the Company’s business. Further, the purchaser must take into account the creditworthiness of its counterparty in case any liabilities arise.
- Other Key Terms: Other terms that are negotiable between a buyer and seller include interim covenants addressing, for example, how the seller may vote on a critical matter arising before closing and whether the seller must exercise pre-emptive rights for a Company equity issuance proposed before the closing, as well as provisions relating to regulatory approvals, tax withholding requirements, stamp duties, governing law, and dispute resolution.
Various Forms of Secondary Transactions. Finally, we note that secondary transactions can take many forms, from bespoke negotiated deals to tender offers made to all target company shareholders, whether for a minority stake or for a majority, controlling position. A number of late-stage growth companies, particularly in the United States, have also permitted their shares to be traded on secondary markets. In this article, we focus on what remains by far the most prevalent type of secondary transaction in privately held companies worldwide – where the investor directly negotiates a purchase of a minority stake with one or more target company shareholders. Most of the issues raised here will apply to other types of secondary transactions as well.
Ground Rules for Secondary Deals – and Variations
The main source for these ground rules are the Company’s Shareholders Agreement or Investor Rights Agreement (each of which we refer to in this article as the Shareholders Agreement). The Company’s organizational documents, and any confidentiality agreements and side letters with shareholders, may also contain applicable requirements or conditions. Further, an investor must consider the corporate law of the Company’s jurisdiction of organization, as well as any regulatory approvals that could apply to the investment.
1. Investment construct and transaction structuring
Investments in private companies through secondary acquisitions may appear, at first glance, to be “take it or leave it” opportunities with little room for negotiation. However, sophisticated investors still evaluate all the key aspects of the investment construct as they would with primary investments, and they will typically find room for negotiation and creativity on critical deal terms.
Securities and Rights to Be Acquired
A critical first step in any secondary purchase is understanding the type and terms of the securities for sale (including, as applicable, liquidation preference and rights in regard to dividends, voting, anti-dilution, and conversion), as well as the matrix of rights and obligations that an investor would assume upon becoming a shareholder. Often, a selling shareholder holds more than one class of shares with different rights and preferences, and both diligence and negotiation may be required for the purchaser to find an acceptable mix of securities, with an appropriate price. In regard to the purchaser’s rights, it is important to determine whether the selling shareholder has any particular status or denomination and whether that status or denomination would be assignable to the purchaser. These points will require careful review of the Shareholders Agreement, together with an understanding of the relevant corporate law framework, which varies across jurisdictions. Some of these rights and obligations will often be negotiable, as we discuss in Section 6 below. And, importantly, as we discuss further in Section 7 below, certain key rights may, as a contractual matter, be held by the seller individually and may not be automatically assigned to the purchaser in the sale – in which case, the transaction documents must specifically effectuate the assignment of rights.
Terms of the Purchase
There is significant room for negotiation and creativity in the terms that a purchaser can negotiate with the seller (for example, as to purchase price, representations, warranties, and indemnities). This rule applies even where there is a developed “market practice.” Sophisticated investors understand as well that what is commonly understood as market practice changes over time and, in any case, applies only to a small subset of companies in a limited number of markets.
A further point for investors to evaluate is the profile of the seller, as the investor’s counterparty. One important aspect of counterparty profile is that strategic and financial investors will have often negotiated different types of rights and obligations in the Shareholders Agreement and that the new investor would step into (in the absence of further negotiation, as discussed in Section 6 below). Additionally, if the seller is a special purpose vehicle, as is often the case with financial investors, the new investor will have to consider its financial wherewithal and whether to require any recourse – and, if so, in what form (such as parent guarantee) – in the case of any breach by the seller, as we discuss further in Section 9 below. Finally, an investor may consider whether to push for the Company to be a party to its purchase agreement with the seller. In some cases, the Company’s involvement might delay the overall process, but in other instances – especially where the Company’s consent is required for the transaction or if the purchaser is concurrently making a primary investment in the Company – the purchaser will find it helpful to have the Company’s contractual commitments.
Tax Efficient Structuring
Finally, an investor should consider its preferred holding structure from a tax perspective (taking into account the form of investment returns and the associated tax and withholding tax consequences) and also prepare to take into account the seller’s tax-related requests regarding the acquisition structures and mechanisms. For example, a seller might have specific requests for the purpose of qualifying for particular treaty benefits.
2. Company Cooperation in the Sale Process
A threshold question in any secondary transaction is whether the deal can be done without the Company’s consent. The answer to this question often sets the tone for negotiations. But, regardless of whether the Company’s consent is strictly required, it will almost always be in the purchaser’s interest to develop a proactive strategy to “win over” the Company to ensure that their goals are aligned at least during the term of the investment.
Importance of Company Cooperation
Cooperation from the Company can facilitate many aspects of a secondary transaction, beyond fulfilling any consent requirement. For example, the Company is in the best position to satisfy a purchaser’s due diligence expectations (see Section 3 below). Additionally, the Company’s willingness to negotiate or waive certain terms of the Shareholders Agreement that may apply to the new investor (such as a restriction on holding competing investments) can make the difference between an attractive and unattractive or prohibitive investment opportunity (see Section 6 below). Further, in regard to regulatory approvals required for the investment, it may not be possible to conduct a definitive regulatory analysis without confidential information from the Company, and the regulatory filings may require information that only the Company possesses.
Understanding the Company’s Thought Process
Most private companies (and often the major shareholders backing them) are wary of new investors who suddenly appear in their cap table. At the same time, most companies, on reflection, will prefer to replace a shareholder eager to exit with a new investor that supports their long-term vision and prospects. Well-advised private companies understand that different shareholders have different investment horizons, goals, constraints, and value additions to the company’s success. If early investors and employees have a path to liquidity through secondary sales, founders and management teams will face less pressure to rush a premature IPO or other exit transaction. In addition, secondary transactions can raise the profile of the Company in the marketplace, indicating the company is “in demand” and helping set the stage for further financing rounds at increased valuations.
Winning Over the Company
While the best strategy to win over the Company will depend on the particular facts, common themes include demonstrations by the new investor of its:
- understanding of the Company’s business model and strategic goals;
- expertise in the Company’s market;
- network of experts or affiliated companies that may help the Company grow or form partnerships;
- financial capability to fund future growth;
- medium or long-term investment horizon;
- track record of supporting other portfolio companies and their management teams; and
- if the investor has any competing portfolio investments, its understanding of and willingness to address any conflict of interests that may arise (as we discuss further in Section 6 below).
3. Conducting Appropriate Diligence
Diligence is usually more limited in secondary transactions. The Company may be slow, or even unwilling, to facilitate the diligence process. After all, the Company is not receiving the investor’s money. At the same time, adequate diligence is important for an investor because it cannot expect the contractual fallback of representations, warranties, and indemnities relating to the Company in its purchase agreement with the seller, unlike in a typical primary investment (see Section 9 below).
Gaining Company Cooperation
As noted in Section 2 above, gaining the Company’s cooperation can greatly enhance the diligence process. The Company controls most of the information that a prospective investor will want to see, and interviews with key management can provide a perspective on the Company’s prospects and strategy that are not available through review of financial statements or other documents. As a further example, most growth companies have an exit and liquidity strategy (that is, to achieve an IPO or company sale), and understanding that strategy, as well as the Company’s progress toward executing it, will be a critical area of diligence for most investors. In this regard, the Shareholders Agreement likely sets out some parameters on the Company’s exit strategy, but a cold read of the documents will not provide a holistic view on this fundamental point. That said, there are still avenues for an investor to perform diligence when the Company is not collaborating, as we discuss below.
Access to Confidential Information from the Seller
If the Company is not cooperating (or has not yet been approached), a threshold question is whether the seller can share the Company’s confidential information in the seller’s possession (whether contained in a diligence report or information received by the seller as a shareholder or through its representatives on the Company’s board of directors). The answer is not always straightforward. The seller may be subject to overlapping and inconsistent restrictions – for example, through differing confidentiality restrictions in the Shareholders Agreement and the seller’s Subscription Agreement with the Company. Further, there may be additional restrictions on the ability of the seller to share information it has obtained through any of its representatives on the Company’s board.
Sophisticated investors can use diligence techniques that do not rely on Company-generated information. These include market surveys; interviews with major customers, suppliers, and other business partners; and background checks on founders and key members of management. Further, depending on the jurisdiction, some key legal information about the Company may be publicly available. Even where the Company is fully cooperating in an investor’s diligence, market diligence provides a different and important perspective on the story the Company is telling.
Requirement on the Company to Facilitate Diligence
In anticipation of the issues described above, sophisticated investors will often push for terms in the Shareholders Agreement that facilitate diligence by prospective buyers. Confidentiality restrictions can specifically allow for disclosure of confidential information to potential transferees, and the Company may be willing to agree to cooperate in any diligence process, for example, by assisting in preparing an information memorandum and allowing site visits and management interviews. In practice, these terms in the Shareholders Agreement might not guarantee prompt and enthusiastic participation by the Company in a given diligence exercise, but it is still desirable for investors to have the weight of the contract on their side.
If the investor has a competing company in its portfolio, then the investor should perform “self-diligence,” ensuring that it complies with relevant legal requirements (if any) regarding clean teams or fiduciary duties. This exercise may also require the investor to ensure that it does not breach any of the contractual requirements it is a party to, whether under any Shareholders Agreement of the competitor company or any other agreements, such as any obligation not to make competing investments, to give the competitor company prior disclosure of any such investment, to provide such a “corporate opportunity” to the competing company, or to establish “clean teams” between the existing and the new portfolio investment.
4. Consent Requirements
If the Company’s consent is required for the transaction pursuant to the Shareholders Agreement, then approaching the Company sooner or later is unavoidable. But consent requirements are not always black and white, and investors can sometimes structure around them.
Company Board Discretion to Block Transfers
One form of “hidden” consent requirement is the broad discretion sometimes granted to the Company’s board of directors to refuse to register transfers. This discretion is sometimes not apparent in the Shareholders Agreement and found only in the Company’s organizational documents or corporate law in the relevant jurisdiction. If directors have this right, then the Company’s consent to the transfer may effectively be required.
Prohibited Transfer Lists
Another “hidden” consent requirement can arise from a list of prohibited transferees, which are included in many Shareholders Agreements. In certain cases, this list could be quickly amended to block a transfer to the investor. Further, the investor may be affiliated with an entity on the restricted list, which could trigger a consent requirement.
Consent Required to Avoid Adverse Consequences – Such as Inadvertent Triggering of Liquidation Waterfall
A secondary transaction might trigger undesirable consequences under the Shareholders Agreement, requiring waivers or consents to avoid those consequences. As an example, the transaction might constitute a change of control under the Shareholders Agreement. Even if the new investor is not acquiring control, the seller might be losing control. Change of control could trigger a range of consequences, including the ability of other shareholders to require liquidation in accordance with their liquidation preferences, or the fall-away of transfer restrictions or non-compete obligations on the founders or key management. If a new investor wants to avoid any of these consequences, then consent to the secondary transaction may effectively be required (subject to any shareholder approval thresholds contained in the Shareholders Agreement or organizational documents).
Structures to Avoid Consent Requirements
Different transaction structures may be available to avoid the contours of Shareholders Agreement consent requirements, but this requires careful analysis of the terms of the Shareholders Agreement. For example:
- Upstream Transfers: The investor may be able to acquire the entity that holds the seller’s shares in the Company, assuming that indirect transfers are not expressly captured under the consent requirements of the Shareholders Agreement restriction (however, note that many Shareholders Agreement will attempt to capture this type of indirect transfer).
- Total Return Swaps: The investor and seller may enter into a contractual arrangement that gives the investor the economics (and potentially the governance rights) of a direct investment in the Company.
However, these structures pose several risks and challenges, including (1) greater complexity (and cost) to structure and document; (2) greater counterparty risk (e.g., in a total return swap, the investor must rely on the seller to pass along economic benefits and appropriately exercise the seller’s Shareholders Agreement rights); and (3) most importantly, the risk that the transaction may be invalidated, whether based on a differing interpretation of the transfer restrictions of the Shareholders Agreement or based on anti-avoidance principles. These risks require careful assessment in light of the particular contractual restrictions and other facts and circumstances.
5. Navigating ROFR, ROFO, and Tag-Along Rights
Many secondary transfers are subject to a right of first refusal (ROFR) or right of first offer (ROFO), as well as a tag-along right in favor of the Company’s other investors (and sometimes the Company itself can exercise the ROFR or ROFO). While there are many variations of these terms, ROFRs and ROFOs generally allow the Company’s other shareholders to have the first opportunity to buy the shares that the new investor wishes to acquire. A tag-along right, by contrast, allows the other shareholders to sell shares to the purchaser on the same terms as the original seller, thereby reducing the number of shares to be transferred by the original seller.
Effect on Transfer Process
The purchaser will want to evaluate the applicable transfer restrictions as early as possible in the process, including to determine if the deal is subject to a strict ROFR or a more liberal ROFO.
- Typical ROFR: In a typical ROFR, the purchaser and seller negotiate a full deal (including price and other terms), and then the seller must disclose that deal, including the identity of the purchaser and all material terms of the transaction, to the other shareholders. The other shareholders are then invited to step into the purchaser’s shoes and complete the deal. As a result, ROFRs often have a chilling effect on secondary transfers. Faced with a ROFR, a prospective purchaser is less incentivized to spend considerable time and resources conducting diligence and negotiating a transaction if that deal can be pre-empted by other parties at the end.
- Typical ROFO: In contrast to the typical ROFR, a ROFO process can begin before the purchaser and seller have negotiated a full deal. Often, the seller is not required to disclose the purchaser’s identity to the other shareholders of the Company. The seller will instead name the price at which it is willing to sell, together with other material terms of the sale. If the other shareholders do not accept those terms, then the seller is free to conclude a deal with the purchaser at the same price (or at a higher price) and otherwise on terms no less favorable to the purchaser than those offered to the other shareholders. However, the investor must be wary of any “match rights” in favor of the existing investors that may have the impact of turning the ROFO into a ROFR and the potential investor into a mere stalking horse.
Risk of Transfer Being Invalidated
It is important to ensure full compliance with (or obtain valid waivers of) any ROFR, ROFO, or tag-along provisions, including notice and timing requirements. Otherwise, the transfer could be invalidated. Many Shareholders Agreements state that any purported transfer that has not been made in compliance with the relevant ROFR, ROFO, and tag-along restrictions is “void ab initio,” i.e., entirely void and invalid.
Tag-Along Risks – Assignment of Rights
If the purchaser intends to acquire rights under the Shareholders Agreement specific to a particular seller (as we discuss further in Section 7 below), the tag-along process could frustrate that assignment of rights. If the seller assigning the particular rights is “crowded out” by other tagging shareholders (that is, if the original seller can transfer only a small portion of the total shares to be sold to the purchaser because other shareholders have elected to sell in the transaction as well), then the relevant rights might not be assignable to the purchaser under the terms of the Shareholders Agreement. This risk should be addressed in the purchase agreement and, depending on the nature of the rights and the specific terms of the Shareholders Agreement, may also require an amendment to the Shareholders Agreement or a side letter between the purchaser and the Company.
ROFR/ROFO Risks – Partial Exercise
The investor’s purchase agreement should also address the consequences of partial exercise of any ROFR or ROFO. Otherwise, the investor may find itself required to purchase a much smaller stake – perhaps below the relevant Shareholders Agreement thresholds for exercising key governance rights (thereby depriving the acquirer of key non-economic rights) – at the same price per share.
Structures to Avoid ROFR/ROFO Requirements
The same alternative structures used to avoid consent requirements (see Section 4 above) may also be used to avoid ROFR, ROFO, and tag-along requirements. But the same risks apply – and the risk of challenge may be even greater if other shareholders feel they were cheated out of their ROFR, ROFO, or tag-along rights.
6. Variations to the Terms of the Shareholders Agreement
A purchaser in a secondary transaction does not normally have leverage to renegotiate key terms of the Shareholders Agreement – for example, to change the size of the board, to supplement the list of investor veto rights, or to enhance the investors’ exit rights. However, new investors often seek specific waivers and amendments. Here, again (as discussed in Section 2 above), it is important to have a strategy to “win over” the Company, as the Company can normally reject each of these requests.
One of the most troubling terms for a new investor is often a non-invest restriction, which restricts the seller from investing in businesses that compete with the Company. This restriction might be unacceptable to the new investor; in fact, the new investor might already hold portfolio investments that would breach these restrictions. If so, this point must be negotiated with the Company. Possible compromises here include one or more of the following: (1) “grandfathering” existing competing investments so the investor does not have to make any divestitures; (2) limiting the information to be provided to the investor (for example, limiting disclosure of operating data of a particular business line that operates in the same sector as the competing portfolio company of the investor); (3) the investor establishing internal information walls and “clean teams”; and (4) the investor agreeing not to appoint anyone to the board of directors of the Company who is serving in a similar role at the competing portfolio company.
Other Investment Limitations
A seller might have agreed to other restrictions or limitations on its investment rights, particularly if the seller has a very significant shareholding in the Company or competes with, or invests in companies that compete with, the Company. Some of these restrictions could include (1) a standstill obligation, where the seller cannot increase its shareholding beyond a certain percentage without Company or founder consent; (2) voting restrictions, where some or all of the seller’s shares are subject to vote neutralization or “cut-back” or subject to a voting proxy in favor of the Company’s founder or another party; and (3) obligations on the seller to maintain “clean teams” and information walls related to Company information. The Company may well have to be persuaded to “give up” these restrictions against the new investor, which underscores the importance of a proactive approach to winning over the Company (see Section 2 above).
Variations to the Shareholders Agreement may also be necessary if the seller has undertaken affirmative obligations that the new investor cannot (or does not wish to) assume. In the case of a seller, which is itself an operating company, these may include commitments to provide the Company with certain intellectual property licenses or other commercial support or to give the Company a “first look” right when the selling shareholder operates in the Company’s territory.
Other terms that may be addressed in a side letter with the Company (if not an amendment to the Shareholders Agreement) include (1) broader carve-outs to confidentiality restrictions (for example, if the Shareholders Agreement does not permit disclosure to lenders or limited partners), (2) waivers of the corporate opportunity doctrine (if relevant under the corporate law applicable to the Company), (3) specific information rights that are critical to an investor, (4) tax reporting and cooperation covenants from the Company, and (5) the Company’s agreement to implement “state of the art” compliance covenants and policies.
Key Purchase Agreement Terms
In this section, we focus on key terms that a purchaser can negotiate or address in its purchase agreement with the seller.
7. Assignment of Seller’s Rights
Contractual rights do not automatically “attach” to shares being transferred and must be specifically addressed in the transaction documents.
Key Rights Affected
Key rights that must be contractually assigned may include (1) a shareholder’s right to nominate directors to the Company’s board of directors; (2) veto rights; (3) information, access, and inspection rights; and (4) exit and liquidity rights, such as registration rights in or following an IPO. Some of these rights may also be provided under the Company’s organizational documents, but it is always better for the investor to also be able to enforce these rights contractually against the other parties to the Shareholders Agreement.
Assignability of Rights
The assignability of contractual rights must be permitted by the relevant contract, or consents must be obtained. Shareholders Agreement provisions vary as to conditions for assigning rights. For example, it is common to have Shareholders Agreements where rights can be assigned only in connection with a sale of a specified size (e.g., 10% or more of the Company’s shares), even where specific Shareholders Agreement rights are subject to a lower fall-away threshold for shareholders who already hold these rights (e.g., 5% fall‑away threshold for information rights).
Allocation of Rights
Where the seller is transferring only part of its stake and retaining the rest, it is important for the purchase agreement to address the allocation of the seller’s rights. The default position under the Shareholders Agreement – which may be undesirable – may require the seller and the new investor to exercise such rights jointly.
Subscription Agreement Rights
As diligence, representations, warranties, and indemnities are often very limited in secondary transactions, investors would naturally want to rely on the seller’s Subscription Agreement with the Company, which often includes a much more extensive set of representations and warranties from the Company, together with indemnification or other recourse for damages. The assignability of these rights depends on the terms of the Subscription Agreement. Very often, these rights are not assignable by the seller, without the Company’s consent (and, here, the Company is unlikely to consent). In special circumstances, the non-assignability of Subscription Agreement rights may lead the investor to explore an alternative transaction structure (such as an upstream transfer or total return swap, described in Section 4 above); depending on the particular circumstances, this may allow the investor to benefit from these rights.
8. Purchase Price Mechanics and Variations
Most secondary transactions follow a simple purchase price construct, with an agreed per share price that is not subject to adjustment or holdback. However, other pricing structures are available and may be useful to bridge valuation gaps.
While rare in secondary transactions, earnouts can be a tool to bridge valuation gaps. Under an earnout, the investor pays a baseline price at closing, with further payments based on agreed metrics. These metrics may be financial or operational (such as Company EBITDA or number of subscribers) or even the Company’s valuation as implied in its next equity financing round. Earnouts can be difficult to structure, but, if they are based on Company performance, the investor and the seller may sidestep many of the difficulties that plague earnout negotiations in M&A deals, where Company performance is typically under the buyer’s control and can lead to opportunistic behavior to avoid payouts.
Holdbacks, Escrows, and other Deferred Payment Structures
In secondary acquisitions of minority stakes (as opposed to majority stakes), it is unusual to see any portion of the purchase price paid into escrow, held back by the investor, or otherwise subject to deferred or tranched payment, such as through issuance of a seller note. A corresponding point (discussed in Section 9 below) is that a seller rarely assumes liability for anything more than the most fundamental warranties as to its ownership of the shares and its ability to complete the sale. However, these structures can be adapted for secondary sales if the circumstances warrant. If any escrow is agreed, it is important for the escrow terms to be clearly and thoroughly drafted, including mechanics for claims against the escrow, disputes against those claims, and any agreement for partial or staggered release of the escrowed funds. It is not unusual to see short-form escrow provisions that have been haphazardly drafted, with the apparent intention that the parties would work out the details in the future when a dispute arises – although this is precisely when the parties are unlikely to act constructively to reach agreement.
Seller Rights in “Quick Flips”
A provision that is sometimes requested but rarely agreed is the seller’s right to a higher purchase price if the investor “flips” (i.e., sells) the shares in another transfer at a higher price within an agreed period (e.g., in the six months following the transaction). Sometimes labeled schmuck insurance, this provision should normally be resisted by new investors into a company; it may be more plausible (but is still rare) when one shareholder is selling to another existing shareholder. In any case, this provision is part of the “toolkit” and may help a buyer and seller agree to overall terms.
9. Representations, Warranties, and Indemnities
In marked contrast to primary investments, an investor typically receives very limited representations, warranties, and indemnities in secondary transactions.
The typical warranties are the “fundamental” warranties relating to the seller’s ownership of the shares (free and clear of liens, voting proxies, and the like) and its ability to sell those shares, including the absence of litigation or claims relating to the shares or the share sale.
Additional Seller Warranties
The seller should also be required to address its compliance with the Shareholders Agreement, as the new investor will typically be responsible for all of the seller’s Shareholders Agreement obligations pursuant to a joinder or deed of adherence. This latter point should also cover full compliance with any ROFR, ROFO, or tag-along provisions, as described above. Finally, if the transaction is structured to include an acquisition of an entity that holds the Company shares, a typical set of “special purpose vehicle” warranties is essential (including as to valid formation, absence of business activities and liabilities, capitalization, seller’s ownership of SPV shares, etc.).
Sellers typically resist all warranties related to the Company’s business and financial position. That said, depending on circumstances, some limited Company-related warranties may be justified. For example, a seller could warrant that (1) to its knowledge, no material adverse change has occurred since the date of the Company’s last audited balance sheet and (2) the seller has disclosed to the investor all of the financial reports provided by the Company.
Big Boy Warranties
It is customary for sophisticated sellers to propose so-called “big boy” representations, where the purchaser acknowledges that it is a sophisticated party, that it has made its own independent assessment of the risks involved in the transaction, and that the seller could possess material, non-public information regarding the Company that has not been disclosed to the purchaser. While a purchaser might be tempted to resist this clause, a sophisticated purchaser may well consider making the clause reciprocal, as the purchaser, through its due diligence, might have obtained better current information on the Company than the seller possesses at the time.
In rare cases, it may be possible for a purchaser to negotiate warranties related to the Company’s business and financial position from the Company itself. This is most likely to occur where the Company is facilitating the selling shareholder’s exit (whether voluntarily or pursuant to an exit right in the Shareholders Agreement). The Company is more likely to provide warranties if the purchaser is concurrently making, or committing to, a primary investment in the Company as well – and, of course, the purchaser’s prospects are maximized if it has “won over” the Company, as discussed in Section 2 above.
Even if the investor has negotiated only limited warranties, it must consider if it will require recourse (and, if so, what recourse) against the seller for any breach or in case the transaction is invalidated (for example, if the parties have taken an aggressive approach to structuring around consent requirements). Breach of warranty is typically a very low risk once the transaction has been completed, assuming compliance with all requirements of the Shareholders Agreement, but the risk may not be entirely eliminated. While rare in secondary sales of minority stakes (as opposed to change in control transactions), an escrow typically offers the most certain form of recourse. Where the seller is a special purpose vehicle of a private equity fund or similar financial investor, a more common recourse mechanic (although still subject to negotiation) is some form of contractual backstop from a creditworthy party (such as the fund itself). This may take the form of a letter of guarantee, letter of comfort, or even equity commitment letter; alternatively, the creditworthy entity may become a direct party to the purchase agreement and undertake any indemnity obligations directly.
Cap on Liability
Sellers often push for a cap on their potential liability, but purchasers can often resist any cap lower than the purchase price itself, as most, if not all, of the seller’s representations and warranties are “fundamental.” A purchaser may also then seek a reciprocal cap on liability and may further provide that it will have no additional liability to the seller once the purchase price has been paid in full.
10. Other Key Terms
A number of other key terms in the purchase agreement are negotiable between a purchaser and seller, including those highlighted below.
Voting and Veto Matters
If the seller is entitled to vote on or veto any significant Company matters between signing and closing, the investor may seek a consent or consultation right. Care should be taken that these rights do not represent “gun-jumping” of any regulatory approval requirements or of any transfer restrictions under the Shareholders Agreement. From a seller’s perspective, if these rights impact how a seller’s director on the Company’s board must act, exceptions for the director’s exercise of fiduciary duties will be appropriate.
If the Company proposes an equity issuance before closing and the seller has pre-emptive rights to participate, the investor may seek to require the seller to exercise those rights and then sell the newly acquired shares to the investor. In certain circumstances, this could be critical for the investor to maintain a shareholding percentage that allows it to exercise key governance rights.
Where a secondary transaction is subject to a ROFR or ROFO, a purchaser is well advised to require that a minimum number of shares be available for purchase. In many cases, the purchaser would not be willing to pay the same price for a fraction of the shares that it expects to buy. Similarly, if the purchaser may be buying shares from multiple sellers (for example, if tag-along rights are exercised), the purchaser may provide that it is not required to purchase any shares unless and until all sellers are simultaneously prepared to transfer the relevant number of shares.
Even where the purchaser is not acquiring “control,” the investment may require regulatory approval. This analysis will be jurisdiction-specific and will flow through to the terms of the purchase agreement, such as (1) closing conditions for the relevant approval, (2) an appropriate “long-stop” date based on an assessment of the timing likely required for approvals, and (3) covenants governing the level of efforts that each party must expend to gain approvals.
Withholding tax is often applicable to secondary transactions, especially in Southeast or South Asian deals. To the extent withholding tax applies, a purchaser must decide whether to (1) actually withhold taxes and remit to the tax authorities, which offers the strongest protection but also requires extensive cooperation from the seller; (2) allow the seller to directly negotiate and pay the applicable taxes, subject to an indemnity backstop; or (3) allow the seller to directly negotiate and pay the applicable taxes, subject to an escrow. The parties must also navigate other practical issues, such as foreign exchange regulations for purposes of making the tax payments, foreign exchange risks during the escrow period, and the like.
Transfer taxes, stamp duties, and similar obligations may or may not be applicable in a given jurisdiction. Local market practice and negotiating leverage often dictate how the burden of these expenses is split, as they could be borne entirely by the purchaser or the seller, or split equally.
Sophisticated investors will generally prefer a commonly used governing law for commercial transactions, such as New York, English, or Hong Kong law. With rare exceptions, the governing law does not have to track the jurisdiction of the Company or of the seller.
The venue for dispute resolution does not have to follow the governing law. As an example, in Southeast or South Asian deals, it is not uncommon to see Singapore as the arbitration venue in a purchase agreement governed by English law.
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The points above represent many of the key complexities and “traps for the unwary” associated with secondary share sales in privately held companies. By understanding these ground rules and market terms, investors can better take advantage of the opportunities that secondary transactions present and take care when negotiating Shareholders Agreements and Subscription Agreements in the first instance, in anticipation of future secondary sales.
This post comes to us from Morrison & Foerster LLP. It is based on the firm’s memorandum, “Buying into Private Companies: 10 Points to Note for Secondary Share Acquisitions,” dated July 30, 2020, and available here.